Fri, 01 Jan 2010

Foreign Investment: Direct versus Portfolio

Ever since the Asian crisis, there has been a sort of consensus that foreign direct investment (FDI) is the best and most stable form of capital inflows while foreign portfolio flows (FII in Indian parlance) are more volatile and therefore less desirable.

Ever since the global crisis began, I have been reading a lot of financial history (starting with the last 500 years and slowly going further back). It now appears to me that the aversion to the volatility induced by portfolio flows is extremely short sighted.

In the long run, the volatility gets washed out and what counts is the average growth rate of the economy. The short term (high frequency) is all noise (volatility) while the signal (mean) is apparent only in long time series (low frequency). Lessons drawn from short time series of data are probably wrong.

Looking back at some of the major emerging markets of the nineteenth century (US, Canada, Australia and Argentina) puts things in a totally different perspective. I particularly enjoyed the discussion about nineteenth century US in Chapters 7 and 8 of Atack and Neal, (The Origin and Development of Financial Markets and Institutions; From the Seventeenth Century to the Present, Cambridge University Press, 2009).

Of all the big emerging markets of the nineteenth century, the US relied most on portfolio flows and Argentina relied the most on foreign direct investment. By 1890, the results of the different trajectories were quite apparent.

In the long run, the volatility of the growth rate is largely irrelevant; it is the average that counts. Despite frequent financial crises and corporate bankruptcies, the US grew faster. More importantly, it was also able (despite the damage inflicted by populist politicians like Andrew Jackson) to build a domestic financial system that ultimately made it less dependent on foreign markets and institutions.

Applying that historical lesson would suggest that India should remain friendly to foreign portfolio flows while developing domestic financial markets. We must simply learn to live with the volatility and occasional crises that come in their wake.

Posted at 13:37 on Fri, 01 Jan 2010     6 comments     permanent link

Comments...

R Sivakumar wrote on Fri, 01 Jan 2010 16:47

Re: Foreign Investment: Direct versus Portfolio

Thanks for a pointer to a book that I think I should read.

I have myself felt that the development of domestic capital markets in India would have far greater impact than trying to chase FDI. If portfolio flows can be the catalyst for improvement in market infrastructure, let us encourage them for that improvement.

In this context, I wonder why there is so much regulatory opposition to the development of the debt capital markets? I do not use use the phrase regulatory opposition lightly. In the late 90's and earlier this decade the debt markets were certainly more vibrant than today. Even the relatively better-off government bond market is more illiquid than it used to be. It seems strange that quotes for Indian rates are sometimes finer in the offshore swap markets as compared to the onshore rates.

vs wrote on Fri, 01 Jan 2010 18:40

Re: Foreign Investment: Direct versus Portfolio

On a somewhat related note, Schiller has a recent article on trills as an additional source of funding (govt):

http://www.nytimes.com/2009/12/27/business/economy/27view.html?_r=3&emc=eta1

http://mpettis.com/2010/01/china-new-year-and-one-more-vote-for-gdp-adjusted-bonds/

• R Sivakumar wrote on Mon, 04 Jan 2010 15:33

  Re: Re: Foreign Investment: Direct versus Portfolio
  

  That's an interesting idea for a government that cannot find willing lenders. If you look at the government bond market:

  To provide a "risk-free" benchmark- Argument for fixed rate bonds. Problem is: government can use inflation to erode the real value of bonds.

  To solve the inflation seignorage- Issue inflation-linked bonds. Problem: does not provide investors participation in real growth.

  To allow investors to participate in real growth+inflation- Issue GDP linked bonds.

  All the above ideas are good, but found unnecessary in a command banking system (such as in India and China), where credit is not directed to where returns are best. The solution is simply to force investors to buy bonds (SLR in India) or force interest rates low (China). The latter makes the risk-reward trade swing in favour of govies.

  Pravin wrote on Fri, 08 Jan 2010 18:22

  Re: Re: Foreign Investment: Direct versus Portfolio
  

  And here is a very good blog dismissing the trills for the sham they are

  http://alephblog.com/2009/12/27/not-so-cheap-trills/

Pradeep wrote on Sun, 03 Jan 2010 12:12

Re: Foreign Investment: Direct versus Portfolio

Nice read. But why is that the case? In the sense why a country depending on portfolio flows seems to, on average in the long term, benefit more than a country which depends on FDI?

Tax preparation wrote on Fri, 08 Jan 2010 15:22

Re: Foreign Investment: Direct versus Portfolio

Nice article, its too much informative Thank you for sharing